Case Study: Should This Start-Up Take VC Money or Try to Turn a Profit?

Unable to solve their impossible problem, VV and Reza went out for a ride. Miles down the California coast, they parked their bikes under the eucalyptus outside a winery conference center. It wasn’t a random stop. They knew that FundersPlatform, a rival to their start-up, AndFound, was holding a networking event there, and they were curious about what sort of crowd it had drawn.

They soon found out.

“VV! Reza! What are you guys doing here?” It was their old friend Cynthia Finlay, a well-known angel investor in Silicon Valley.

“What are you doing here?” asked VV. He’d assumed that FundersPlatform wouldn’t be able to attract high rollers like Cynthia. Reza seemed taken aback, too. He looked down and busied himself with his bike.

“Just because I love you and your site doesn’t mean I ignore what else is going on,” she replied. “These guys do a good job of matching us angels with promising start-ups. It’s like speed-dating. I must have talked to 20 entrepreneurs today. But don’t worry,” she added. “They’re no threat to you. Their fees are killer—thousands for the companies, $500 per deal for the investors. They’ll never be able to compete with free!”

Free. That was the towering advantage of AndFound, an online platform that connected investors with a curated selection of start-ups. It’s why the service, launched in 2012, had grown so popular with users. But it was also potentially a business model weakness—it was the impossible problem that had prompted the contentious discussion at the office and then driven VV and Reza onto their bikes.

VV put his helmet back on. “You’re right,” he said. “You can’t beat a free service—as long as it survives.”

A Hard Slap at VCs

Friends since their engineering days at Stanford, VV Tikekar and Reza Rastegar had each been involved in several start-ups before joining forces on AndFound. At first it was just something to do between jobs—a way of “giving back” to the entrepreneurial and angel communities, while also giving a good hard slap to Silicon Valley’s competitive, exclusive, information-hoarding venture-capital culture. Reza, especially, relished that, having experienced firsthand—and hated—the VC world as an associate and partner at a couple of firms.

It was an ugly business, they believed. VC firms knew so much more about funding than entrepreneurs did, but they rarely offered any guidance and tended to back only people they already knew. Where was the objective, helpful advice and merit-based access to money?

AndFound had started as a blog on topics such as how to find funding, pick a team, and make a capitalization table. When VV and Reza began to get queries from entrepreneurs asking for referrals to angel investors, they decided to build a comprehensive database of funder profiles, using information collected from the investors themselves—what they were interested in funding, past levels of investments, and so on. Soon VV and Reza were playing middlemen, putting founders in touch with people in their database. The next step was to hire engineers to develop technology that would enable start-ups to create online profiles, like Facebook pages, and investors to filter results—for example, allowing them to search only for founders who’d previously worked at Google or graduated from Harvard or MIT.

In fact, they deliberately chose not to charge fees because they sensed that doing so would drive away the best entrepreneurs and investors, and that once they lost the top-caliber participants, the whole thing might very well unravel. They assumed that, eventually, as the site became more and more valuable to the start-up community, some way to monetize the business would emerge.

Before long AndFound carried information on 10,000 investors and 100,000 companies, ranging from hair salons to tech start-ups. Screening algorithms highlighted the best new entrants so that they could be individually reviewed and featured. It was a full-blown social-networking hub, with participants “following” people and companies, commenting on posts, and “liking” other users’ updates. As a result, everyone in the start-up community was using it—even VCs.

VV and Reza weren’t the only players in the space, however. Numerous accelerators in the Valley and elsewhere provided coaching for entrepreneurs and opportunities to pitch ideas to investors. One was AndFound’s competitor FundersPlatform. In one sense, it was well behind AndFound—it had only a few thousand investors on its site—but in another it was way ahead: It had raised $10 million in funding since its seed stage. AndFound had opted not to raise a penny beyond its first round.

Never Say Never

Cycling back toward Mountain View, Reza yelled something over his shoulder that got lost in the wind. VV pedaled hard, caught up, and shouted, “What?”

“I said we’re never going to charge our users for meeting each other!” Reza shouted back.

VV pumped his legs harder to get out in front of his partner and stayed there for the rest of the ride. Reza’s categorical opposition to charging fees was what had stalled the business-model conversation earlier in the day. VV knew they needed to continue that discussion, but they weren’t going to do it on their bikes.

He thought back to a meeting the previous month with Hap Berger, an investor even wealthier and more connected than Cynthia. He’d flown VV and Reza to Los Angeles on his private jet, sent a car to drive them to a Newport Beach marina, and taken them out on his boat, which was so big VV actually got lost on it. The purported goal was to look for the huge, weird-looking ocean sunfish that sometimes lolled just below the surface of the water, but VV and Reza knew Hap’s real intention was to kick the tires of AndFound and decide whether to invest.

He was talking very informally, but it was about real money—at least $10 million, maybe as much as $25 million—which VV thought the company desperately needed in order to hire staff, improve its technology infrastructure, and sustain the kind of growth it had seen so far. The problem was that Hap was looking for explosive revenue growth. VV explained why he and Reza cared so much about “best” and “free,” and why AndFound wasn’t chasing revenue yet. Then Reza used the “never” word—and that was that. Hap, his mood suddenly sour, said it was probably too late in the day for sunfish and turned back toward shore.

Case Study Teaching Notes

Ramana Nanda teaches the case on which this story is based in the course Entrepreneurial Finance.

What interested you about this story?

The landscape for early-stage financing has been shifting rapidly over the past decade, and online platforms are transforming the industry.

What are the lessons of your original teaching case?

Building a two-sided platform is tough, because founders need to attract high-quality participants on both sides—in this case, entrepreneurs and investors. If one side declines in quality, the other will too. That’s why in their early years, platforms prioritize user experience and expansion of the user base ahead of revenue. But investors want to see cash flow potential. Decisions about timing and which business model to choose can have a big impact on success.

How do students respond?

They tend to be skeptical about the start-up, until they do the numbers. Then they realize that it could easily command a $1 billion valuation.

VV understood why Reza was so adamant about not charging user fees. He too saw AndFound as a vital service to all the extremely talented but unconnected entrepreneurs and investors who were suffering through a badly broken funding system. But, in VV’s opinion, the site couldn’t survive for much longer—much less keep pace with its competitors—without an influx of cash.

There were alternatives to charging user fees, and VV and Reza had discussed them on the way home from their visit with Hap.

First, there was the company’s new Talent portal. Aware of how difficult it could be to find entrepreneurial talent, VV and Reza had set up a section of the AndFound site to connect start-ups with job seekers in technology hubs around the country, allowing them to apply filters, just as investors could with companies. They were now making 2,000 introductions per week on behalf of 30,000 candidates, and estimated that the service could save a typical company $25,000 or more in recruitment fees per candidate. The service was currently free, but it was certainly a potential source of cash that wouldn’t conflict with AndFound’s primary mission of linking the best investors with the best start-ups.

The tools and documents that VV and Reza had developed to help facilitate the funding process were another potential source of revenue. Many had already been made available for free, in the form of blog posts, but perhaps AndFound could set up a paid membership or subscription play for access to them.

But none of these revenue model options seemed to be a silver bullet; so, as had happened so often before, VV and Reza put the decision off.

Point of Contention

It was so late when they returned to AndFound’s offices after their bicycle ride that everyone else had gone home. Physically spent, VV and Reza sat down in chairs and simply looked at each other.

“Personally, I think we can manage for quite a while as we are,” Reza finally said. “But OK, I’m game for a funding round.”

“For that, we need a revenue model. If our aim is to raise $10 million to $25 million at a pre-money valuation of $100 million to $150 million, high-quality investors will need to see how, exactly, we’re going to get to a billion-dollar valuation in a few years so they can get their required return.”

“All those things we’ve been talking about—the Talent portal, the tools, the shared brokerage fee, the carried interest,” Reza said. “Let’s get serious about investigating them as monetization strategies.”

“But are they really going to take us where we need to go?” VV asked. “They’re probably capable of generating some decent money, but even in combination, they’re probably not going to generate anything like the growth we need.”

“I think you’re wrong there. We won’t know until we try. But even if you’re right, we’ll just have to come up with other options—something else that taps into third parties’ interest in what we’re doing,” Reza said.

“But we can’t rely on just tiny slivers of our offerings and community. We need a revenue stream that comes out of our core business and strength: connecting good start-ups with good funders.”

“OK, so let’s postpone the funding round,” Reza said, sounding frustrated. “In our business, six months is a century. Our traffic could be up by 200% in that time, which could drastically improve the potential value of all the revenue streams we’ve talked about. It would change our valuation and leave us less vulnerable to dilution from any Series A funding. I’ve said this before, but I’ll say it again: If we commit to a model now, we risk hamstringing our business.”

Now VV was frustrated. “Six months? We’re barely able to handle everything we already need to do.” Improving algorithms, maintaining the site infrastructure, continuing to review all the start-ups and select the ones to feature to investors—the list went on and on. “As the site degrades, we’ll lose business,” VV continued. “FundersPlatform may not look like much of a competitor now, but wait until it starts to pump its new capital into its operations—while we get weaker.”

“We’re never going to lose business, because we’re the best thing that ever happened to the start-up community,” Reza said. “And we’re free.”

Question: Should AndFound commit to a revenue model right now?

The Experts Respond

Kevin Laws is the COO of AngelList, a website that connects entrepreneurs with angel investors.

Committing to a business model prematurely can be fatal. If you start to monetize your offerings too early, you may end up as an also-ran in a market dominated by a company that was able to grow on capital instead of revenue. That’s because monetization efforts can draw team focus away from critical growth efforts, alienate customers, and stall momentum. Ads, for example, can sour users on core offerings, and paid products can generate less word of mouth than free ones.

Monetization efforts can alienate customers and stall momentum.

Ideally, VV and Reza should find deep-pocket investors who share their vision and who believe in AndFound’s ability to execute. With that kind of backing, they will be able to focus on growth for the foreseeable future and think about monetizing only when AndFound finally dominates its market.

Facebook found such investors. So did YouTube. Because AndFound is in the financing business, VV and Reza are better positioned than most founders to find believers among their users and raise capital without too much dilution.

Of course, it’s possible that they won’t find such investors. But that doesn’t necessarily mean that their vision is flawed. It could be that they struggle to communicate that vision persuasively. Or it could simply be bad luck in finding true risk capital. Whatever the reason, if the right investors don’t come along, VV and Reza will need to monetize some of the site’s offerings, such as its Talent portal, but they should bring in just enough revenue to keep the lights on and continue growing. They should think of those revenue options as interim sources of needed operating funds rather than as “solutions” to the company’s ultimate revenue-model question. (This is the “eat ramen under your desk rather than pay yourself a salary” phase, and a lot of start-ups go through it.)

That’s not to say that VV and Reza should put the business-model question out of their minds entirely. A “culture of free” can quickly become entrenched among stakeholders. It’s critically important that the founders make progress toward establishing a sustainable, lucrative revenue model that users will accept so that the company knows how to monetize when the time comes. You often hear about the importance of “product–market fit”; a start-up also needs to think carefully about how its revenue model matches the market’s needs and expectations.

VV and Reza should develop a nuanced understanding of the kinds of revenue initiatives that might be seen as contrary to AndFound’s mission of connecting the best entrepreneurs with the best investors. Protecting that mission is essential, because it is what will attract and retain employees, users, and investors through ups and downs. Any move that violates stakeholders’ view of what the company stands for would be risky—even foolish.

Jennifer Lum is an angel investor and entrepreneur. She is a cofounder of Adelphic and of Apricot Capital and an adviser to start-ups at MIT, Techstars, and 500 Startups.

A start-up can’t live on seed capital forever. VV and Reza can get away with postponing commitment to a core business model for a while longer, but in the meantime they should be testing revenue strategies and learning about what may or may not work. They should be thinking about how and when to introduce paid features to the AndFound site.

There’s a negative perception in the tech community that some companies and individuals take advantage of inexperienced entrepreneurs who are going through the fundraising process. VV and Reza sense this acutely.

So I certainly understand Reza’s concern about abandoning their “free” model. He may assume that if the site starts charging fees, the community will see AndFound as just another predatory company making money off entrepreneurs—like FundersPlatform in the story, which charges steep fees to bring entrepreneurs and angels together. I’ve seen events where start-ups have to pay $5,000 just for the opportunity to pitch their ideas to investors. Practices like that are rightfully frowned on.

But AndFound has been up and running for several years, and by now VV and Reza have proved that they have entrepreneurs’ best interests at heart. They have stayed true to the site’s mission of giving founders greater access to capital and increasing transparency in the fundraising process. They have opened up funding opportunities on both sides of the market.

In light of the number of active and engaged users on their site, VV and Reza should have confidence in the trust they’ve established with them. AndFound’s community is getting a lot of value from the site, and it should recognize AndFound’s need to build a sustainable business. As long as AndFound is up-front and transparent about fees, I believe users will be willing to pay for some of the site’s features and services.

I’m surprised by the founders’ reluctance to experiment with revenue-generating ideas. I’m a big believer in testing, and there are plenty of opportunities for AndFound to learn more about customers’ willingness to pay. VV and Reza have done a great job of inventing simple but valuable ways for entrepreneurs, investors, and job seekers to interact and engage with one another; they should now focus on testing each of those innovations as a potential source of revenue.

Take the Talent portal. The service saves organizations a lot of money. A professional recruiter typically charges a quarter to a third of a new hire’s first-year salary. Companies already paying recruiting fees would probably be willing to pay AndFound a smaller fee for similar services.

Talent isn’t AndFound’s core business, of course; but in the early stages of company building, it’s not uncommon for start-ups to generate revenue from noncore activities. I’ve worked at start-ups that derived substantial early revenue from products that weren’t the eventual core business.

Of course, a young company needs to be wise about how it allocates its limited resources. AndFound should be unwavering in its focus on its central mission: helping to broker deals. But it should also experiment with other revenue options on a small scale, targeting segments of its users.

There’s no time to lose. Reza is absolutely right that for a start-up in a rapidly growing sector, six months is a century.